Modeling Hybrids: Handling Credit

Market practitioners, while being fully aware of the caveats involved, will rely on a credit spread to discount cash flows from a hybrid bond. The discount rate that has to be plugged into a pricing model is sourced from the market prices of corporate bonds. There is, from a theoretical point of view, a clear link between default risk and the level of those credit spreads. The credit default swap market is the main source of values for the default intensity to plug into a jump-diffusion model. Accordingly, the corporate bond market can also be a reliable source to understand the credit risk of a particular issuer. Stochastic intensity is often modeled as a Cox process. This illustrates how concepts of interest rate dynamics are copied into the world of default risk.